The problem with the IBD lists is that these stocks are often priced for perfection and are susceptible to being suddenly dumped by profit-taking funds after a large rally. Whenever the market falls, the IBD list falls the hardest, and it isn’t uncommon for fallen stocks to never again recover. The IBD list uses momentum, but the problem is the funds that have engendered the rally in the first place can terminate the momentum at any time and then you’re screwed. I present below a method that uses momentum but eliminates a lot of the risks.

Every time someone comes up with a ‘rule’ for trying to time the market (Dow Theory for example) or some aphorism for making money (buy when there’s blood), I can name many examples of when these rules failed.

So that’s a lot of stuff that doesn’t work.

When the market became difficult in 2014 and picking stocks and trying to time reversals became impossible, I decided I needed a new method that eliminated the timing and guessing and replaced it with fundamentals and statistics, hence the linear combination method. What I do is I form a linear combination of ETFs, resulting in a high Sharpe ratio and where the fundamentals bode well for the underlying trend. Then I leverage the position using deep in the money options and futures.

A linear combination is simply a basket of ETFs, each with a weighing factor. The sum of the weights equals one.

For example: I may go long $100k SPY (a single ES contract)and then offset it with a short of $50k of the European market (VGK or IEV). SPY would have a weight of 6/10 and IEV would have a weight of 4/10. This has a 6-month Shapre of of excess of 4:

So what I did is I created the perfect ‘momentum stock’ that doesn’t have all the idiosyncratic risks associated with stock picking. It’s much harder for funds to manipulate the markets of entire countries than individual stocks. Studies have shown that momentum strategies can generate excess returns. From Wikipedia: For instance, it was shown that stocks with strong past performance continue to outperform stocks with poor past performance in the next period with an average excess return of about 1% per month. Without company related risks and by using leverage, the excess risk-adjusted returns are probably greater. Europe and the SPY have a correlation of .8, meaning it would be very unlikely for Europe to rally and the US markets to not follow; likewise, it would be unlikely for the US markets to crash and Europe to not crash as well. So they follow each other closely, but because the US has better economic fundamentals or due to some other factors, Europe hedges most of the downside and participates only a little in the upside. Unlike traditional put option based insurance or buying VIX futures, there is much less extrinsic value decay and you get the benefit of a smooth equity curve. Some people hedge with out of the money puts. This is terrible because those puts aren’t cheap and will expire worthless 95% of the time. Over many months and years, this can cause substantial loss of capital for a collapse that may never come. But if shit hits the fan, Europe will save the day. And if the market surges, Europe will lag. if nothing happens, unlike an option or VIX futures, there is no decay.

There are many combinations like this. Maybe I’ll post some more later.